| Summary
The fourth quarter of 2007 was yet another volatile quarter, with only one of three
positive months. According to the Standard and Poor’s 500, the stock market posted
a +1.48% October, followed by a November of –4.40% and closed the year with a –0.86% December. This equates to a 2007 return of 3.53%. The Core(1) strategy
posted an October of +0.72, followed by a November of –1.58% and closed the year
with a December of +0.90%. This provided a 2007 annual return of 7.10%.
Risk
During this period our Standard deviation ended at 4.39 compared to SP 500 at 9.64!
(Remember the lower the number the better).
Rights/Wrongs
Those same errors I reported in third quarter ended up proving to be correct calls for
the fourth quarter and ultimately the year. Our underweight to equities and our focus
on fixed income boded well in the fourth quarter—the month of November in
particular when we picked up an additional 2.82% over the market. In addition, I
suggested an underweight to small capitalized companies, which turned out to be the
worst performing style for the year, as reported by Russell’s in its year-end Russell
2000 (small cap index) performance report, posting a –1.57% (with small cap “value” stocks losing as much –9.78%). On the sector front, yet again our
underweight to energy was a wrong call as energy was the best performing sector,
but our underweight to domestic financials and consumer discretionary sectors more
than offset, as the financial sector alone represents 20% of the market compared to
11% comprised by the energy sector. My call on the market for the year (which I
will address in much greater detail later) was off. I expected a –6% to –11% year and
the market ended at +3.53%. My response is that a forecast is just that—a
barometer—and our performance besting the market attests to the management
beyond forecasting.
*For those of you studious recipients you will notice a change in our historical numbers. This was a result of
our third party certification process to maintain our AIMR/GIPS standards of performance reporting. Standard
and Poors only provides one (1) return number for these years, real return. There are two columns
listed for the SP 500, (1) Total Return for the reinvestment of dividends (CORE does not include the reinvestment
of dividends) and (2) the actual return for the Standard and Poors 500.
Trailing Returns
Quarterly Performance vs. S&P 500
Discussion
2007 was a good year for our portfolio on a relative basis. We posted a 7.10% return compared to
the S&P 500 of 3.53% and we did it with 50% less volatility. I believe however, that 2007 was a
bad year for the markets.
My forecast for 2007 was that the market would end up in the down range of –6% to –11%. The
market and its makers proved me wrong with a +3.53% return and proved themselves wrong, as
well, with their forecast of +7%. It certainly felt like a negative performance year despite the annual
number. I argued the entire year that investors should be allocating away from equities,
should seriously consider taking profits where it made sense, should be aware of increased volatility
and should prepare for a negative year. All actual conclusions seemed to make sense except
one—the actual return. Understand that forecasts are barometers and not prognostications, and I
am not a soothsayer.
There are three primary asset classes which comprise the securities industry; stocks, bonds, and
cash. Stocks represent ownership in a company, bonds represent a loan to the company and cash
is simply cash (commonly placed in money market type investment vehicles). Investing in the
market is often perceived, when broken down to the simplest concept, the attempt of buying low
and selling high. Ultimately, however, the investor is actually attempting to create a portfolio
intended to provide total return.
Total return is comprised of two components, price appreciation and yield. Price appreciation is
merely the rise of the underlying value of the security and yield is the dividend rate or interest
that is paid while you own the vehicle. The objective for an investor should be to focus on each
of these components individually first and then identify the most suitable combination relative to
their stated investment goals and objectives. This is referred to as asset allocation.
As an equity manager, I carry a bias toward owning stocks, but I carry a greater bias of positive
total return. I recognize the attraction to buying stocks low and selling them higher, but at the
end of the day, it should be more about total return and the volatility taken along the way. As
such, entering 2008 should be done with caution. The last two weeks of the year were disappointing
from a natural progression perspective because they didn’t accomplish much other than
to provide a –3.2% off the market. This may lead to a “catch up” in January which may mean a
rough start.
As I write this review (the first week of the new year) I recognize that the market has lost all of
its 2007 gain in the first couple of trading days and gone negative for the trailing 12 months. In
my opinion, that could have easily happened the week before, in 2007. Take it for what you will
but also recognize that we have experienced three tops in 2007, one in May, another in July and
the third in October. From these tops to the end of 2007, the markets have performed accordingly:
If we extend this activity to include the period of the first week of trading in 2008, (through January
8th) we observe:
My forecast for 2007 was a –6% to –11%. Apparently I was early from a calendar perspective,
but understand that market cycles do not occur simultaneously with the calendar, and we are in
volatile times.
As I have mentioned on numerous occasions, one of the last signals that managers look for is the
three month trailing average of the market to fall below –1.8% or worse. Our matrix goes back
to 1950 and when the matrix goes negative, it indicates either the bottom of the current correction
(as it did in June of 2006—see 2nd quarter review 2006) or the first stage of a bear
From the beginning of this bull market (2003) we have been monitoring this and witnessed a
slight negative on July 21, 2006. As such, we took precautions and hedged the portfolio only to
watch our puts on the market expire worthless. The trailing look back went –0.0005, which
when applying acceptable standard deviation (as this is not a precise science) the market could
have gone either way. Consistent with our management discipline, we took the conservative
route and hedged. When the matrix is this close to “going negative” (or on the bubble), managers
can elect to become aggressive, believing that it is a bottom and others become defensive to
protect principal in case it is the beginning of a bear.
Since July 2006 we have experienced two more negative indications. The first occurred on August
16, 2007 when the trailing average dropped below –1.8% and again on August 28, albeit
slight. The market rebounded through October 9, due primarily to the Federal Reserve’s actions
with rates, reiterating my comments in the third quarter review, violating the natural progression
of capital markets.
As of the first trading day of 2008 this matrix has gone negative, and through January 8, a deep
negative. As such, this would indicate that we are in a bear market. Most of the attention seems
to be on whether or not our economy is going into a recession and we have yet to hear much
about our current market cycle location.
If we are indeed in a bear market, our research indicates that the beginning was July 19, but the
synthetic support (by the Feds) pushed the possible top to October 9th. I warned investors that
the Fed’s actions would cause repercussions in the future. This is one of them. Despite my philosophy
that the market attempts to take as much from as many for as long as it can, the market
does allow investors time to adjust. Historically in a bear period an investor loses 2/3rds of the
value in the last 1/3 of the bear. If this bear is of average duration of approximately 18 months,
that would put the last 1/3 in the late stage of 3rd quarter or 4th quarter of 2008. If it is a shorter
bear cycle, due to the Federal Reserve, this one is going to feel worse than the bear of 2000-2002.
I do not believe the total loss will be greater but the shorter duration and the market’s tendency to
get back on track will cause greater volatility in a condensed time frame, which will remind investors
that markets are volatile. January should provide a rather good indication of the direction
and duration.
If this is a bear market, an investor should expect additional downside from the end of 2007 in
excess of 20% from the peaks. In determining durations and support for market cycle location
we evaluate other aspects associated with the economy and the markets.
I have provided multiple news releases covering events during the previous quarters to provide
insight away from our firm to demonstrate the significance of the current market and economic
environments. There are so many to choose from for the fourth quarter I fear I would overwhelm
you. Suffice it to say, the status is this: recessionary fears have increased and the Fed has
attempted to control the underlying economy, but is now forced with the fears of inflation.
As the Fed eases money supply (lowers rates and increases the supply of money) it drives down
the value as it is in greater supply. (Case in point, the US dollar is currently worth less that the
Canadian Dollar). This reduction in the value of the currency makes the prices we pay higher on
a relative basis. This is inflation. So I expect a prominent issue early in 2008 will be inflation. The marketers of the markets attempted to spin this condition in 2007 and encouraged all onlookers
that the Fed needed to lower rates because the markets needed it and paid no attention to the
effects this would have on the underlying economy. One week following this decision and carrying
into 2008, they are seeing the repercussion of that action.
I believe the market has become so convoluted that even basic valuation perspectives have been
skewed. On December 19, Morgan Stanley (a company that we have owned over the years but currently
do not), reported their first quarterly loss in the company’s history. The analysts had anticipated
a loss of about 39 cents per share, but company’s loss turned out to be far greater—a whopping
$3.61 per share loss. In my tenure as a manager, I’ve observed that when a company misses
the mark by that much, bloodshed is soon to follow. What did the stock do that day, it went up
over 4%. Can you believe it? 4%!
The explanation was that now everyone knew how bad it was. My response is just because you
know how bad it is, doesn’t make it good—it’s still bad! That warrants an upward movement of
over 4%? Not to me.
In addition, we have CEOs stepping down from major financial firms—Bear Stearns, Merrill
Lynch and Citigroup, to name a few. It is during periods such as these when you have an extended
bull market, weak underlying economic conditions, major industry leaders getting fired, and unexplained
phenomenon (the only way I can explain Morgan Stanley) that it is time to reduce exposure
to equities.
In 1990, Harry Markowitz was awarded the Nobel Prize for his conclusions as it pertains to the
impact that proper asset allocation has on long term total return relative to an investor’s stated
goal. His model provided an optimal static combination of stocks and bonds which would provide
the highest return relative to the volatility associated with portfolio.
Typically, investors accept the increased volatility associated with equities relative to the growth
potential that they represent. An investor should recognize the relationship between suggested or
expected return and the volatility associated with such and evaluate this relationship and attempt
to maximize its efficiency. We refer to this as alpha.
For example, the 12-month forecast for Merrill Lynch (December “Investment Strategy Update”)
was adjusted “slightly” from 7% to a mere 3% and, for me, the outlook was negative.
This is significant for many reason, but for the discussion as it pertains to asset allocation, it is
paramount. If cash/money market equivalents are yielding over 4% and the forecast for equities
is less than this yield, investors should perceive little value in assuming greater potential volatility
in owning stocks. If an investor can appreciate a fixed rate which is greater than an unknown
rate, it would benefit the investor to overweight the fixed component To actively make adjustments to a portfolio on the asset allocation level is commonly referred to as “timing” the market. I would concede, to make these adjustments frequently would qualify for
such classification, but to make adjustments during transitions in market cycles that have profound
indications and general consensus of a more volatile equity market and expected returns
less than fixed rates, is not timing, in my opinion, but rather common sense.
To put it into perspective, the adjustments I refer to that occur as a result of a transitioning market
cycle occurs a few times a decade. Recognize that most mutual fund investments, for example,
should be deemed long term investments, yet the average annual turn-over is greater than
80%. That equates to a significant amount of change on a mere calendar basis. If that does not
slide into a “timing” category then I do not know what would.
Sectors
The significance of sector weightings, as I have mentioned repeatedly, becomes an indicator
as an investor navigates from a bear to bull market environment. Understand that market
cycles do not occur on a calendar basis nor do all sectors top as the market peaks or
bottom when the markets trough. As such, during the upward movement the sectors will
each top before the aggregate market and accordingly they will bottom along the way to the
bottom of the bear.
As such, it is advantageous for the investor who has allocated toward cash or liquid fixed
positions to take advantage of the valuations on a sector level and actually build a portfolio
during the bear cycle and be prepared for the transition into the next bull. This approach is
what allows an investor to preserve principal during the bear and still provide the opportunity
to generate returns during the first stage of the bull. This is significant if you realize
that most managers who perform well during a bear struggle during a bull and visa versa.
Their strategies are built to perform well during certain environments and it is the unique
manager that actually demonstrates earnings (particularly above market) in both periods,
especially in the transition years.
The market is a composite of 10 sectors. It reflects the weighted average of each component.
As such, during no time period will every sector perform better than the collective.
Therefore in every period some sectors perform better than the composite and some perform
less than the composite. This unfortunately does not happen on a calendar basis, for
each sector has its own cycle within the overall market cycle.
The following chart illustrates the performance of each sector of the S&P 500 for 2007,
according to Standard and Poor’s.
As the market has progressed naturally it is common to witness the falloff of the discretionary
sector (another confirming indicator of market cycle location). It finished second to the
financial sector as the sub-prime fallout began to erode financial company valuations. On
the specific stock level as it pertains to the financial companies, pay attention to price relative
to book. If the companies do not go under, an investor stands to build a good base if
the company has a significant market cap (>$50billion) and trades below book value. This
would entail taking positions in companies of a sector that most investors will be running
from. Understand that not all of these companies will go out of business. As such, the key
is identifying those that will make it (i.e. the reference to the largest cap) and recognizing
the opportunity of the valuations, but it will take investor fortitude to be a buyer. This is an
action that we cannot take as it violates certain aspects associated with our standard deviation
parameters. However, on the individual investor level it may be worth their time to
investigate.
Looking ahead to 2008, and understanding that asset allocation will play a critical role, if
you are going to own stocks, focus on those that have historically demonstrated buoyancy
in a soft or bear market and/or have fallen in advance of the aggregate market, that maintain
solid fundamentals and that are demonstrating value. These sectors may include consumer
staples, health care, some telecom, and selected utilities. Here is a suggestion for
2008:
Geography
Our reduction to the overall allocation to equities also adjusts our exposure to foreign markets.
As a percentage allocated to equities, I suggest a very selective allocation to developed
markets as I believe any downward pressure in the U.S. will not be ignored by other
developed markets. I would maintain an estimated 30-35% allocation of total equity
weightings: Here are the results globally for 2007 from MSCI/Barra.
Summary
We have a US dollar that has weakened (to an extent it is even weaker than the Canadian
dollar), we have the Federal Reserve attempting to avoid a recession while creating greater
probabilities of inflation, commodity prices that are near all time highs, and we have gone
through five years of a bull market in equities. Investing in the market requires the acceptance
of certain variables. As an investor, the more variables you can remove the greater
control you have.
In light of the current economic and market conditions, I would conclude that the probability
as it pertains to the price appreciation and dividend/yield components would suggest
that allocation to fixed vehicles that yield a rate greater than an anticipated appreciation (a
large variable) makes sense. Consider global yields on a maturity and credit quality basis
and you will be surprised by how high they are on a U.S. comparative basis. The first
quarter will more likely experience high levels of volatility and if you are sitting in an
overweight position in equities, it will test your mettle. I would encourage the reduction of
as many variables as possible and focus on yield.
See you next quarter,
Bo Beckman
(c) The Oxford Private Client Group
www.theoxfordpcg.com
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